Currency Wars: The Phantom Menace

The last thing the global economy needs right now is anything that would hamper
or derail economic growth. Unfortunately, there appears a growing specter of
this occurring. Brazil and Japan's recent decisions to intervene in the currency
markets follow a disturbing trend. If policy makers are not careful, present
dynamics may precipitate a worldwide economic slowdown, brought about by protectionist
pressures and exacerbated by political motivations globally.

Merk
Insights provide the Merk Perspective on currencies, global imbalances,
the trade deficit, the socio-economic impact of the U.S. administration's
policies and more.

Competitive currency devaluation appears to be the name of the game for many
Treasury departments and central banks alike. It may also be a key driver of
the recent strength in gold; in such an environment, an asset that retains
its intrinsic value is increasingly sought after. Vietnam instigated a devaluation
of the dong earlier this year, Switzerland, a country renowned for stability
and neutrality, attempted to devalue the Swiss franc relative to the euro,
rhetoric out of Washington has intensified surrounding China's decision to
continue to peg its currency closely to the U.S. dollar, and now Japan and
Brazil have both decided to take unilateral action, intervening to weaken their
respective currencies.

For many countries, the motivation to devalue the currency is to spur export
growth. Devaluing a countries' currency is akin to providing a subsidy to the
export sector, as it makes that country's exports relatively cheaper. The flip
side, is that it intensifies inflationary pressures, as a devalued currency
means that imported goods become relatively more expensive; for a high-growth
developing economy, the combination of an undervalued currency and increased
production and labor costs can cause substantial domestic inflationary pressures,
as evidenced in China.

Moreover, devaluing a currency may lead to escalating international political
strains, global criticism and intensification of protectionist pressures. Maybe
the most prevalent example being the U.S. criticism leveled at China, culminating
in the passing of legislation aimed at pushing up the value of the yuan. When
one currency is artificially weak, other countries may be put at a disadvantage,
as other countries' goods and services may be less competitive in the global
market. Such a situation can and has encouraged retaliation, whether through
competitive currency devaluations or outright trade wars, in the form of additional
import taxes and duties levied, or sanctions placed, on specific exporting
countries deemed to be manipulating their currencies. Trade wars are good for
no one: they create inefficiencies and slow down global growth. In a period
of lackluster global growth, this is the last thing we need. Recent references
of a "race to the bottom" and worldwide "currency wars" should not be taken
lightly - given that the global economic recovery remains on unsteady ground,
the implications of another slowdown in growth could be disastrous.

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We have discussed at length the very questionable currency policies pursued
by the Swiss National Bank (SNB) - see our analysis here -
and have been heartened to see that the SNB appears to have come to its senses
and discontinued this approach.

We have long argued that China should allow its currency, the yuan or renminbi
(CNY), to appreciate, as it may help alleviate much of China's domestic inflationary
pressures. China has continued to rely on rather rudimentary banking regulation
to curb lending and growth in monetary aggregates to rein in inflation, and
recently announced a plan to allow the currency to trade within a wider trading
band. It turns out that "wider band" is a relative term; the CNY has appreciated
by a little over 2% since the announcement in June. The Chinese are unlikely
to allow the currency to float freely overnight, as even small moves to the
currency affect many businesses throughout the Chinese economy; the process
is likely to play out over many years. This hasn't stopped U.S. politicians
from taking a swipe.

While Treasury Secretary Geithner's recent testimony to congress fell short
of labeling China a currency manipulator (and was much less aggressive than
many politicians had hoped for), the message out of Washington is clear: the
U.S. is increasingly unhappy with China's exchange rate policies. In our opinion,
however, China is unlikely to allow the currency to appreciate simply because
of threats from Washington; rather, they will act in the best interests of
China. Moreover, the debate over China's currency policies is to some extent
misguided: many politicians argue that a stronger CNY will generate jobs in
the U.S. To a degree, this may be true: U.S. based companies may think twice
before making the decision on additional hires should the CNY appreciate.
But it is unlikely that much of the jobs that already left as part of
the outsourcing bubble that occurred throughout the last decade will return
to the U.S.; the U.S. simply cannot compete on cost; these jobs are likely
to migrate to lower value producing countries, like the Philippines, Vietnam
or Thailand.

These countries produce goods at the low-end of the value chain, have limited
pricing power and are therefore forced to compete predominantly on price. As
such, and in our opinion, these countries are more likely to instigate competitive
devaluations of their currencies. With an ever-deteriorating consumer outlook
in the U.S., the incentive for these countries to instigate competitive devaluations
of their currencies grows significantly. Indeed, Vietnam has already intervened
in the currency market, actively weakening the value of the dong (VND). With
a continued weak consumer outlook in many western nations, it is quite likely
that further competitive currency devaluations occur in the lower-value producing
Asian nations.

Brazil's economic expansion, and the substantial appreciation of the Brazilian
Real (BRL) share similarities to the Australian experience. Rich in commodities
and natural resources, both countries have benefited from insatiable demand
out of Asia, particularly from China. Both economies have rebounded strongly
and in both nations, the unemployment rate has declined steadily, and remains
well below the levels seen throughout much of the western world. Both central
banks have led the world in interest rate increases, with the Reserve Bank
of Australia raising the target rate by 1.5% since the latter half of 2009
and Brazil's central bank raising rates by 2%. Increased investment demand
has flowed into both nations and as such, both nations' currencies have appreciated
substantially: relative to the U.S. dollar, the Australian dollar (AUD) has
appreciated 39.9% for the period March 31, 2009 to September 30, 2010; during
the same period, the BRL appreciated 37.7%.

When it comes to exchange rate policies, the similarities stop there. Brazilian
finance minister Guido Mantega has been particularly vocal about the government's
concerns surrounding the strength of the BRL, describing the present situation
as an "international currency war". Brazil previously imposed a 2% tax on foreign
purchases of fixed income securities and stocks in October 2009, in an attempt
to curb gains in the currency. Brazilian policy makers have now stepped up
their offensive, increasing the tax on inflows to 4% and buying billions of
dollars in the market in an attempt to stave off further currency appreciation.
Speculation is rife that further steps will be taken, or that direct capital
controls may be implemented. The government is certainly not taking this issue
lightly, sending the ominous message that they are "not going to lose this
game."

Conversely, Australia has been a leading proponent of the virtues of a free-floating
currency, namely protection against inflationary pressures and boom-bust cycles.
The Reserve Bank of Australia has lauded the flexible exchange rate as one
of the great success stories of Australian economic policy making. In their
opinion, Australia's free floating currency has helped mitigate exaggerated
economic booms and busts and has protected against high, and volatile, inflation.
Currency price movements helped the economy adjust more smoothly to the current
boom in the resource sector, helped protect the economy in 2008 when global
risk aversion was at its peak, and during the Asian financial crisis and the
bursting of the U.S. tech bubble.¹

Brazilian policy makers may do well to heed their Australian counterparts:
the appreciation of the BRL has undoubtedly helped alleviate inflationary pressures
in Brazil, helping bring inflation back towards the target rate of 4.5% from
over 6% previously, and could help bring the rate to a more price stable level.
While Brazilian policy makers may or may not succeed in destroying the currency,
one thing is for sure: they run the very real risk of alienating Brazil from
global markets. In our opinion, Brazilian politicians' motivations are flawed:
on the one hand they believe the strong appreciation of the BRL will stifle
economic growth; on the other hand the talk of imposing rather draconian measures
to stem demand for the currency will likely drive investment away. These are
the same investment flows required to drive economic growth in Brazil.

Potentially more damaging globally is if these actions prompt other nations
to follow a similar path. Already we have seen South African, Peru, and Mexican
politicians (amongst others) uttering misgivings about the strength of their
respective currencies. Should we enter a period of competitive currency devaluations
globally, the risks of trade wars may increase substantially, which could come
with serious consequences for global markets.

Countries that run current account deficits, including the U.S., may be at
the greatest risk should a global trade war scenario play out, as these countries
are reliant on foreign investors to finance their deficits. Should additional
tariffs, capital controls or sanctions take effect (a very real threat given
recent legislation surrounding currency manipulation), the U.S. may lose the
trust of international investors, who may in turn pull funds out of its markets,
putting pressure on the U.S. dollar.

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up for our newsletter to stay informed as these dynamics unfold. We manage
the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and
the Merk Hard Currency Fund; transparent no-load currency mutual funds that
do not typically employ leverage. The Merk Hard Currency Fund can be considered
an international fixed income fund with a firm commitment to the short end
of the yield curve. To learn more about the Funds, please visit www.merkfunds.com.

Kieran Osborne is Senior Analyst and member of the portfolio management group
at Merk Investments; he is an expert on macro trends and currencies and has
significant international market experience. Prior to Merk Investments, Mr.
Osborne was an equity analyst at Brook Asset Management, where he worked in
both the Australian and New Zealand markets. He has also worked in New York
for MCM Associates, a U.S. hedge fund.

The Merk Hard Currency Fund (MERKX) normally invests in a basket of hard currency
denominated investments composed of high quality, short-term debt instruments
of countries pursuing "sound" monetary policy. The average maturity of these
debt instruments has historically been less than 180 days.

Both the Merk Asian Currency Fund (MEAFX) and Merk Absolute Return Currency
Fund (MABFX) have historically utilized forward currency contracts to gain
currency exposure. The notional value of these contracts is typically fully
collateralized with U.S. T-Bills or other money market instruments.

The Merk
Asian Currency Fund (MEAFX) seeks to profit from a rise in Asian currencies
versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies
that may include, but are not limited to, the currencies of China, Hong Kong,
Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea,
Taiwan and Thailand.

The Merk
Absolute Return Currency Fund (MABFX) seeks to generate positive absolute
returns by investing in currencies. The Fund is a pure-play on currencies,
aiming to profit regardless of the direction of the U.S. dollar or traditional
asset classes.

The Funds may be appropriate for you if you are pursuing a long-term goal
with a currency component to your portfolio; are willing to tolerate the risks
associated with investments in foreign currencies; or are looking for a way
to potentially mitigate downside risk in or profit from a secular bear market.
For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges
and expenses of the Merk Funds carefully before investing. This and other
information is in the prospectus, a copy of which may be obtained by visiting
the Funds' website at www.merkfunds.com or
calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in
currency exchange rates will affect the value of what the Funds own and the
price of the Funds' shares. Investing in foreign instruments bears a greater
risk than investing in domestic instruments for reasons such as volatility
of currency exchange rates and, in some cases, limited geographic focus,
political and economic instability, and relatively illiquid markets. The
Funds are subject to interest rate risk which is the risk that debt securities
in the Funds' portfolio will decline in value because of increases in market
interest rates. The Funds may also invest in derivative securities which
can be volatile and involve various types and degrees of risk. As a non-diversified
fund, the Merk Hard Currency Fund will be subject to more investment risk
and potential for volatility than a diversified fund because its portfolio
may, at times, focus on a limited number of issuers. For a more complete
discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current
opinion of the authors. It is based upon sources and data believed to be accurate
and reliable. Opinions and forward-looking statements expressed are subject
to change without notice. This information does not constitute investment advice.
Foreside Fund Services, LLC, distributor.